Question

Define Weighted Average Cost of Capital. Carefully distinguish between using book weights, market weights and target weights in establishing the WACC and which set of weights is preferred and why. 7.

Answer 1

A business uses different sources of funds for financing its operations. These have different costs of capital. Hence we need to weigh these costs of capital by the amount used in the financing. Weighted average cost of capital is computed as the sum of market weights of the capital used X their individual costs.

We use the market weights of the sources of finance because the market values reflected the true economic worth of each type of Financing whereas book values may not do so because they are based on historical prices.